Prepaid Interest Paid By Cash-Basis Taxpayers

May 01, 2012

In general, if you are a cash-basis taxpayer who prepays interest on a loan, you are not permitted to deduct all the interest in the year of payment. Under the Internal Revenue Code, you are required to capitalize the prepaid interest and deduct it as if you are an accrual-basis taxpayer. In other words, you cannot take a deduction for interest other than in the year in which it is due. The prepaid interest is allocated to the tax year in which the interest actually represents the cost of using the borrowed money. To allow a deduction of prepaid interest in the year of payment rather than in the year it is due would materially distort your income.

A level payment loan does not result in prepaid interest just because a larger portion of the interest is paid in the earlier years of the loan. However, the IRS is authorized in certain circumstances to treat interest payments under a variable interest rate loan as consisting partly of interest calculated under an average level effective rate of interest and partly of an interest prepayment. But a loan calling for interest at a stated rate that is tied to or varies under the "prime rate" will not necessarily give rise to prepaid interest.

The ban on the deduction of prepaid interest in the year of payment does not affect the determination of whether or not the payment of a fee or charge is considered interest. Instead, it only affects the timing of the deduction. Points or other similar charges paid at the time the loan is incurred are considered interest if they represent a charge for the use of the money. The points are, in effect, a substitute for a higher stated rate of interest and are therefore deductible. However, if the fees are simply charges for services, they are not deductible interest payments even if they are characterized by the lender as points.

Generally, taxpayers who use the cash basis method of accounting are not permitted to deduct prepaid interest or points paid in advance of the period to which they relate. The points are amortized (spread) over the lifetime of the loan. However, points are usually deductible in the year in which they were paid if the following requirements are satisfied:

  • The loan was used to buy, build, or improve a taxpayer's principal home. In order to qualify for current deductibility, the loan must be secured by the home.
  • The payment of points is an established business practice in the taxpayer's area.
  • The amount of points paid did not exceed the number of points generally charged in the area.

Under most circumstances, points paid for refinancing a taxpayer's principal residence are not deductible in the year of payment.